Tax Reform and the Environment:
Paying for Fundamental Tax Reform
Prof. Gilbert E. Metcalf
Department of Economics
Tufts University
Medford, MA 02155
(617) 627-3685
gilbert.metcalf@tufts.edu
June 6, 2005
Executive Summary
I would like to encourage the President's Advisory Panel on Federal Tax Reform to
consider the use of environmental taxes in general and a carbon tax in particular as part of
its mix of instruments to contribute to an improved federal tax system.

A carbon tax beginning at $15 per metric ton of carbon and gradually rising to
roughly $23 per metric ton over the next ten years would raise sufficient revenues
to finance corporate tax integration.

Employing environmental taxes need not put the United States at a competitive
disadvantage internationally. Currently the United States relies less on
environmental taxes (3.3 percent of federal, state, and local tax revenues) than any
other country in the OECD.

In addition to a carbon tax, the Panel should consider the possibility of a permit
emissions tax to capture some of the rents accruing to electric utilities from the
tradable permits under the 1990 Clean Air Act Amendments' SO2 trading program
having been given away rather than sold.
Prof. Gilbert E. Metcalf
Tufts University
June 6, 2005
Tax Reform and the Environment
With the exception of comments submitted by Duke Energy, it appears that no
one has suggested how environmental taxes could help the Advisory Panel achieve its
goals of simplification and greater rationality in the U.S. tax code. I have two points to
make in these comments. First, the United States lags behind most other developed
countries in its use of environmental taxes and charges as a component of its fiscal
system. Second, our failure to avail ourselves of environmental taxes and charges means
we are missing revenue opportunities which could help us tackle important fiscal issues
in our federal budget.
Environmental Charges: an Underutilized Resource
The first point to make is that the United States collects little in the way of
revenue from environmental charges (including taxes) and what little we do collect is
collected in an inefficient manner.1 Even if we include taxes on motor fuels (which are –
strictly speaking – not an environmental tax), environmental tax collections are trivial in
the federal budget. Less than 4 percent of federal revenues came from excise taxes in
2004 roughly two-thirds of which could loosely be described as environmental in nature.
How does the United States compare with other developed nations? Considering
environmental taxes at all levels (federal, state, and local), environmental taxes in the
United States comprised 3.3 percent of total tax revenues in 2001.2 By contrast, OECD
countries as a whole collected 4.9 percent of taxes through environmental taxes.
Germany's environmental tax share, for example, was 7.1 percent; the United Kingdom's
1
See Fullerton (1996) for an overview of environmental tax policy and the high costs of collection.
Francis (1999) notes the decreased use of some environmental taxes in the 1990s.
2
The source for these and subsequent tax share numbers is the OECD Economic Instruments Database.
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Prof. Gilbert E. Metcalf
Tufts University
June 6, 2005
was 7.5 percent; Denmark's was 10 percent. No country's environmental tax share in
2001 was lower than the United States' share.
In short, the United States is at the very bottom of the distribution in terms of the
fraction of government revenue collected through environmental taxes and charges and
an increase in our reliance on environmental taxes should not put us at a competitive
disadvantage relative to our trading partners in the OECD. Let me next turn to how we
might use a green tax shift in the United States.
Green Tax Shifts: Some Possibilities
I'd like to discuss three examples of green tax shifts to illustrate how the Panel
might use environmental tax revenues to help us achieve important fiscal policy goals.
1. Carbon tax to finance corporate tax integration
A study that Kevin Hassett of the American Enterprise Institute and I did a few
years ago explored instituting a carbon tax to finance corporate tax integration (Hassett
and Metcalf (2001)). The idea of a carbon tax combined with a reduction in existing
taxes has been extensively studied.3 The focus on a carbon tax is a natural one given
rising concerns about global warming. Emissions of carbon dioxide (CO2) in 2002
totaled 1,581 million metric tons, according to the most recent report on greenhouse gas
emissions from the Energy Information Administration (2004). A carbon tax is an
obvious policy tool to help reduce carbon emissions. The Congressional Budget Office
estimates that the ten year cost of reducing the double taxation of corporate income by
excluding dividends and capital gains from taxation at the personal level is $266 billion.
Based on CBO estimates, I calculate that a carbon tax starting at about $15 per metric ton
3
See, for example, Bovenberg and Goulder (1996) who consider cuts in the personal income tax financed
by a carbon tax.
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Prof. Gilbert E. Metcalf
Tufts University
June 6, 2005
and gradually rising to $23 per ton over a ten year period could finance this reform. The
research that Hassett and I did indicates that such a reform would have little impact on
the equity values of the affected industries and could in fact lead to increases in equity
valuations for many industries.
2. Environmental taxes to help achieve distributional objectives
The President's Advisory Panel on Federal Tax Reform is charged with thinking
about ways to simplify tax collections and enhance efficiency in a revenue neutral
context. The discussion above illustrates how environmental taxes could help us achieve
considerable efficiency gains through capital income tax relief. My next example
illustrates how environmental taxes can be used to achieve distributional objectives.
A study I undertook a few years ago asked how we might carry out a revenue and
distributionally neutral green tax reform. I hypothesized a green tax shift equal to ten
percent of federal revenues in 1994.4 I modeled a new carbon tax, an increase in the
motor fuels excise tax, new taxes on air pollution (or alternatively the federal sale of
tradable permits giving firms the right to emit air pollution – as currently occurs under
the SO2 trading system for electric utilities and as proposed under the Bush
Administration's Clear Skies Initiative. Finally I modeled a tax on unrecovered waste, a
so called virgin materials tax.
The specific tax rates and amounts collected are not that important for our current
consideration. Rather I'd like to emphasize that a common concern with environmental
taxes is that they are regressive – that is they fall disproportionately on low-income
individuals and households. My analysis confirmed this result when looking at the
4
This is an ambitious goal and would represent new environmental taxes of roughly $200 billion in the
current fiscal year. I am reporting the research in Metcalf (1999) here.
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Prof. Gilbert E. Metcalf
Tufts University
June 6, 2005
environmental taxes in isolation. I then modeled three tax reductions financed by the
new (or increased) environmental taxes. First, I exempted from the OASDI payroll tax
the first $5,000 of tax base for each worker (real $1996). Next, I implemented a
refundable $150 tax credit for each exemption taken in the personal income tax. Finally,
I modeled an across the board income tax cut of 4 percent.
The net result was an essentially distributionally neutral green tax shift. The point
of this exercise was not to make a case for this particular reform. Rather it was to
emphasize the key point that while environmental taxes may be regressive, an
environmental tax reform can have whatever degree of progressivity policy makers
choose. Any regressivity in the environmental tax can be offset by progressivity in the
tax reductions financed by the new revenues.
The broader point in the context of the Advisory Panel's work on tax reform is
that environmental taxes provide an additional instrument to help achieve whatever goals
the panel has, whether they be related to efficiency, distribution, or some combination of
the two.
3. Emission trading permit exercise tax
As my last example of an environmental tax, I turn to cap and trade programs like
the SO2 trading program for electric utilities implemented in the 1990 Clean Air Act
Amendments or the various cap and trade programs such as proposed in the Clear Skies
Initiative. Cap and trade programs such as the SO2 program have a number of attractive
features as recently documented in the 2004 Economic Report of the President. How
permits are allocated is an important issue in their design. The SO2 trading program
grandfathered firms allocating permits to utilities on the basis of historic pollution levels.
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Prof. Gilbert E. Metcalf
Tufts University
June 6, 2005
Grandfathering may make permit programs more palatable to affected industries but it
means the government foregoes valuable revenue it could collect by selling permits to
firms, revenue that comes without the deadweight loss generally associated with taxes.
Economists have long argued that the government should sell rather than give
away emissions permits in order to raise revenue to finance cuts in distortionary taxes.
While this is good advice for future trading programs, it would be difficult to
retroactively begin selling permits from the current SO2 trading system given the banking
and forward purchase of permits that has occurred.
The Panel could, however, propose a permit exercise tax. This would be a tax
levied on any firm that used a permit under the current program in order to emit sulfur
dioxide. In other words, this is a tax on the right to exercise the permit. In 2003 electric
utilities emitted 10.6 million tons of SO2 emissions.5 A permit exercise tax of $250 per
ton would raise $2.6 billion annually. Such a tax would capture a significant fraction of
the economic rents generated by giving the permits to utilities in the first place.
Conclusion
Summing up, I strongly urge the Advisory Panel to consider adding
environmental taxes in general and a carbon tax in particular to the list of tax reforms
under consideration. These taxes would give greater flexibility to achieve important
fiscal reforms elsewhere in the tax code while preserving revenue neutrality and
contributing to a cleaner environment. I would be happy to provide additional
information if the Panel wishes.
5
Burtraw, Evans, Krupnick, Palmer and Toth (2005)
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Prof. Gilbert E. Metcalf
Tufts University
June 6, 2005
Bibliography
Bovenberg, A. Lans and Goulder, Lawrence H. "Optimal Environmental Taxation in
the Presence of Other Taxes: General Equilibrium Analyses." American Economic
Review, 1996, 86, pp. 985-1000.
Burtraw, Dallas; Evans, David A.; Krupnick, Alan; Palmer, Karen and Toth,
Russell. "Economics of Pollution Trading for So2 and Nox," RFF Discussion Paper.
Washington, DC: Resources for the Future, 2005.
Energy Information Administration. "Annual Energy Review 2003," Washington, DC:
Energy Information Administration, 2004.
Francis, Brian. "Federal Excise Taxes, Including the Slow Death of Expired Taxes."
Statistics of Income Bulletin, 1999, (Summer), pp. 185-89.
Fullerton, Don. "Why Have Separate Environmental Taxes?," J. M. Poterba ed., Tax
Policy and the Economy. Volume 10. Cambridge: MIT Press for the National Bureau of
Economic Research, 1996, 33-70.
Hassett, Kevin and Metcalf, Gilbert E. "Environmental Taxes to Finance Capital Tax
Reform," Accurate Prices Program. Oakland, CA: Redefining Progress, 2001.
Metcalf, Gilbert E. "A Distributional Analysis of Green Tax Reforms." National Tax
Journal, 1999, 52(4), pp. 655-81.
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